Little contagion expected from Evergrande troubles

China Evergrande Group is facing a liquidity crisis. With USD 300 billion in liabilities, and some payments due this week, the real estate conglomerate has indicated that it will suspend loan interest payments.

On Thursday (23 September), Evergrande needs to make an interest payment of USD 83.5 million on an 8.25%, five-year USD bond and to pay USD 36 million on a local bond. The loan covenant on the five-year bond stipulates that a default is triggered 30 days after a missed payment. The troubles at Evergrande are not new – it had earlier suspended payments on a variety of structured products.

As a consequence, credit-rating agencies have downgraded Evergrande to levels implying a high probability of default. The company’s outstanding debt is now trading at around 25% of its par value.

So far, serious contagion has been limited to the high-yield bonds of other highly leveraged Chinese real estate companies. A positive sign is the relative stability seen in Chinese investment-grade corporate (USD) bonds. More will be known when Asian markets reopen on Wednesday, after being closed for holidays. We believe that if Chinese investment-grade markets continue to be stable, then the danger of further contagion is likely limited.

In the aftermath of the pandemic and China’s rapid return to growth, the government began to tighten financial conditions, particularly for property developers. The Chinese government believed that some companies had grown too large and were overleveraged. But despite the drive for deleveraging, a larger-than-expected slowdown in the Chinese economy has prompted authorities to institute some ‘’piecemeal” easing measures. The Chinese central bank has, for example, implemented liquidity operations to support bank loans to small and medium-sized companies; and fiscal easing through local government bond issuance is also underway.

Given these measures, we believe that the Chinese authorities will now strike a balance between fighting moral hazard and safeguarding financial stability. We expect that Evergrande’s restructuring (or default), will be carefully managed by the Chinese government to limit its effects on the financial and property markets. With most Chinese financial institutions being owned by the state, it makes sense that the central bank will take steps to isolate the impact of Evergrande as much as possible. Nonetheless, a clear message from policymakers will be needed to shore up confidence and limit spillover effects.

Against a backdrop of news headlines related to Evergrande as well as uncertainty regarding the path of the US Federal Reserve toward higher rates, equity markets have been volatile. Despite a recent decline, year-to-date developed equity markets have performed very well, while emerging markets have lagged. We do not see the underperformance of emerging-markets stocks as a buying opportunity. Instead, market volatility is expected to continue as economies around the world try to put the pandemic behind them and as growth slows after the peaks that occurred when lockdowns ended.

Roel Barnhoorn, Global Head Fixed Income
Fidel Kasikci, Senior Portfolio Manager Fixed Income